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In a development reminiscent of the heady days of 2012 yields on Greek 10yr bonds surged over a percentage point in the two days following the announcement, while the stock market fell by the most on a single day since 1987. 5yr CDS on Greek debt were also up sharply, and even more significantly, the yield curve inverted with 3 year debt started to move above that on ten year debt. Yield inversion on sovereign bonds is often seen as a symptom of potential default as investors demand ever more for holding short term debt.

And the chaos continued all week with 10 yr bond yields rising above 9% and stocks falling another 7.35%, taking the total drop in equities to over 20% (chart from Mike Bird at Business Insider).

The reason for the market panic is obvious, since investors didn't need long to study the Greek constitution and realise that should the current government be unable to summon sufficient votes for their candidate to be approved in the final vote on 29 December, then general elections would become inevitable.

With yesterday's vote this possibility has now become a reality and elections are to be held on 28th January 2015. What's more there is a significant possibility that the radical left coalition - Syriza - will win, and in that eventuality some sort of confrontation or stand-off with the EU Commission and the Troika would become inevitable.

What is worrying investors most is not the fact that Syriza have renegotiation of the country's debt in their programme - with government debt at over 175% of GDP and the economy in deflation some sort of restructuring is inevitable - but the kind of economic programme the new government would try to implement since it would surely be based on a kind of "anti Troika" formula - higher salaries, higher pensions, more government employees, and repeal of the new labour law, just for starters - and these kind of "reverse reform" measures would be hard for Europe's leaders to swallow.

Formally the party do not seek to leave the Euro, their aim is rather to run an alternative economic model within the Euro structure, based on the assumption that faced with the threat of Greek exit Europe's leaders would back down and become more flexible. Investors are nervous since they fear that they may not do so, and that Greek exit may actually ensue.

Long Term Depression

Despite the fact Greece's economy grew by 1.6% over a year earlier in the 3 months to September (making for the third straight period of quarterly growth) this welcome "green shoot" comes on the back of six years of contraction during which time the economy fell by around 25%. The country - and it's citizens - is a lot poorer now than it was then, not to mention the fact that it has been burdened with a lot more debt.

So while growth has returned, it is very modest growth in relation to the fall which preceded it. In addition the country's economy is suffering from deflation, with consumer prices falling by 1.2% in November over a year earlier, the 21st consecutive month of negative inflation. The IMF now forecast that Greek GDP will grow by 0.6% in 2014, but prices will fall by 0.8% meaning that nominal (non inflation adjusted) GDP will be stationary. And this kind of situation could go on for years and years as the country exists a horrendous recession only to enter an extended period of secular stagnation.

Despite the timid, but much applauded, recovery, the macroeconomic data is far from being encouraging, as this screenshot taken from the statistic office website illustrates.

Industrial output is back where it was in 1976, and was down 1.7% over a year earlier in October.

Greece's current account has made huge strides in the right direction, and the balance was even positive in 2013, but this improvement has largely been the result of a reduction in imports (and living standards) and not due to export growth.

As a result the country still runs a sizable goods trade deficit.

So Greece isn't having an export lead recovery, which is what the country really needs. In fact massive sacrifices have been made, many people's lives have been made a misery, yet there is really very little to show for it all. Which is why Syriza is doing well in the polls. With 26% unemployment continuing, surely (the thinking goes) anything would have to be better. Why not try a long shot in the dark?

Whom The Gods Would Destroy They First Make Mad

The horrid little secret about the common currency experiment is that it provided a structure wherein it was very easy to get into trouble (cheap interest, good credit ratings, no current account supervision) but desperately hard to get out of it (no currency to devalue). The big problem for Greece now is to find a way to get the country back to where it was before they got into the current mess while staying inside the currency union? Some would say quite simply they can’t and the conclusion to be drawn is that they should leave the Euro. This isn’t as easy or as obvious a solution as it seems, and in addition many of the other member countries are effectively counter-parties on much of the large external debt that has been accumulated, so in the event of non-payment part of the problem would simply change hands.
Any decision by a member country to cut loose from the Euro is unlikely to be welcomed by the creditor nations, making the idea of a voluntary, negotiated departure pretty unlikely, particularly after Mr. Draghi made his promise. The exiting country would have to do so unilaterally, and face the consequences on debt default and sustained lack of access to international capital markets.

It would be a very messy affair, and in some ways not a decision a person applying a rational calculus would be likely to arrive at. There are so many losses to offset against the gains. Under these circumstances the only conceivable way a deliberate decision to leave could credibly be envisioned would be as a result of one or more of the respective agents being effectively driven “insane” by the constant painful efforts involved in trying to carry out the very large competitiveness correction required while remaining within the currency union. This indeed was the argument I advanced in my essay submission to the Wolfson Prize: a procedure for orderly exit is essentially a worthless document since if anyone does leave the affair won't be orderly, but bitter and fraught with conflict. And this phenomenon of growing political instability was what characterized Argentina before it went careering off the tracks in December 2001.

So just because many might question the rationality of such a decision doesn't mean it won't happen, or couldn't happen as an unwanted side effect of a conflict which gets out of control. Economies on the southern periphery are not recovering (in any normal sense of that word), they are condemned to either frequent recessions or one very long depression, depending on how you classify things, together with protracted deflation and unacceptably high levels of unemployment. The degree of lost competitiveness that was inflicted during the early years of the century - and which is as much an institutional and reputational issue as it is a price one - imply that a decade or more may pass before daylight is seen.

If it ever is.
This outcome is proving very painful for the respective populations. Too long and too painful, which is why we are now seeing a surge in support for organizations like Syriza, or Podemos in Spain, or the 5star movement in Italy. Confidence has steadily eroded in the old political elites, who were trying to convince voters that pigs really could fly (while in many cases lining their own pockets in the process) and more radical political movements are emerging. It isn't that hard to understand. This was always going to happen.

Some, like the FT's Kerin Hope, try to draw comfort from the idea that Syriza may be moderating as the responsibility of holding power looms.

"....the recent market panic belies the fact that Mr Tsipras has softened his rhetoric since Syriza came first in May’s European elections, cementing its lead over the governing New Democracy party in opinion polls.
He professes devotion to the euro while his economic team now holds regular international conference calls in an effort to reassure fund managers that a leftwing government would be able to tackle Greece’s debt problem and would not oppose foreign investment."

But this may be mistaking tactics for strategy. These movements are not about to get incorporated in the mainstream. And the key issue is not likely to be the debt one. As I explained (here) in the summer of 2013 formulas exist for handling this question. What is most likely to divide Athens and Brussels if Syriza win the elections is the nature of the economic model the country will adopt. In this sense Ambrose Evans Pritchard has this one right.

As matters stand, it is more likely than not that a defiant Alexis Tsipras will be prime minister of Greece by late January. His Syriza alliance vows to overthrow the EU-IMF Troika regime, refusing to implement the key demands.
A view has taken hold in EU capitals and the City of London that Mr Tsipras has resiled from these positions and will ultimately stick to the Troika Memorandum.... But the fact remains that he told Greek voters as recently as last week that his government would cease to enforce the bail-out demands “from its first day in office”.

In fact they go further, describing Troika representatives as "criminals" who work to convert the periphery into "German colonies". If you listen hard enough you can hear Podemos leaders saying similar things in Spain.

As Ambrose also points out, Mr Tsipras will be banking on the idea that the EU leaders will back down, and talk turkey. But what if they don't? Their room for manoeuvre on this front is far more limited than it is on the debt one, since others in the south would surely want to follow a similar path if they thought they could. Grexit may be something that no one actually wants to happen, but sometimes things no one wants to happen do.

Sunday, November 16, 2014

The recent move by the Bank of Japan to take further measures to accelerate the rate at which it ramps up its balance sheet took almost everyone - market watchers included - completely by surprise. The consequence was reasonably predictable - the yen has once more fallen strongly against almost all major currencies - and most notably against the USD - and Japan's main stock indexes are sharply up.

On the other side of the balance sheet the cost of imported goods - and especially energy - is expected to rise, real wages are likely to continue to fall, and ex-tax inflation looks set to remain moderate, possibly around 1% - short of the 2% objective but comfortably away from deflation.

Meantime this week's GDP figure show's that the country fell back into recession again in the third quarter with a 1.6% annualized drop following one of 7.3% in the April-June period. The headline number makes it likely Abe will go ahead with snap elections in December, and indeed postpone the second stage of the consumer tax hike which was due to be implemented next autumn.Obviously, if what you are trying to do is stimulate inflation then sending the economy regularly into recession by weakening consumption isn't going to help.

But what all these conflicting signals underline is the lack of clarity about just what the principal objective of Abenomics actually is. Simply creating inflation cannot be the goal. If it is achievable on a sustained basis this inflation has to be a means to something else. For Paul Krugman that something else would be a lowering of the real interest rate via rising medium term inflation expectations. This lower real rate would - so the theory goes - stimulate investment in capital goods and hence provoke an ongoing (and self sustaining) recovery in the Japanese economy after years of sub-par growth.

But what if Alvin Hansen was right, and in economies suffering from structurally weak consumer demand linked to ongoing demographic dynamics (and not simply a balance sheet recession) the principal determinant of productive investment decisions is not the cost of capital but corporate profitability and the anticipated size of the future market? In this case even success on the inflation expectations front would probably not deliver the expected recovery.

And there are downside costs. While financial markets boom, the living standards of the majority of Japanese families continues to fall as real wages drop month after month. It's hard to see consumption booming in this case. Then there is the debt: gross government debt current stands at around 245% of GDP.

It is often argued that in a country running a current account surplus and using its own currency such debt doesn't represent any special problem. I for one remain unconvinced that this is the case. This debt level, among other issues arising, effectively rules out any eventual "normalization" in interest rates since the servicing burden on the government would just be too high. But then - as some argue - this may now be old hat, since the Wicksellian natural rate of interest in Japan may have turned permanently negative. If this is the case, however, why try formulate policy on neo-classical lines working towards a "classic" recovery? A recovery which may never come. If the natural rate is permanently negative we are hardly standing on the ground over which the traditional liquidity trap theory was built.

But it isn't only me who has doubts. Multilateral institutions like the IMF and the OECD also do. That is why they have been conducting debt sustainability analyses, and arguing for the consumer tax hike. Naturally proponents of the timidity trap suggest that such moves to bring Japanese government debt under control is a mistaken sequencing of priorities. First get sustainable inflation going, then get a self-perpetuating recovery, then address the debt the argument goes. But doesn't this beg the question of whether the objective is, in fact, attainable.

The late Karl Popper started to think about what distinguishes science from other social practices by confronting the apparent "irrefutability" of ideological systems like marxism or psychoanalysis. The problem with such world views is that they never seem to be testable, there is never any clearly identifiable fact "in the world" which can refute them. The "timidity trap" argument gives me a horrible deja vu feeling in this sense. Each time things don't work out as planned what Mr Abe and Mr Kuroda have to do is more of the same, no matter if you blow Japan clean out of the water, since the only reason the recommended recipe hasn't worked to date is that the balance sheet expansion and the associated stimulus haven't been big enough. I think it is time Paul came of age intellectually speaking and started to identify for us some concrete indicators which could prove his hypothesis wrong if they moved in the expected direction without producing the expected result, and stop telling us repeatedly that he has normally been right.

What if the Japanese economy simply can't sustain the desired inflation anymore, what if the historical epoch during which that expectation was feasible is now over? Obviously it isn't difficult to generate a certain amount of consumer price inflation if you raise consumer taxes, and again you can also get it if you devalue your currency, and keep doing so. But as we are now seeing, you do need to keep repeating the moves. There doesn't seem an underlying mechanism there waiting to be kick-satrted.

Without more tax hikes last April's increase will simply drop out of the inflation data by the time we reach next spring, and absent the implementation of the Abenomics 2.0 yen devaluation the currency-depreciation-induced inflation was already dropping out. The first round of Abenomics took the yen from 75 to 100 to the USD, the current bout has now taken it to around 115, but to keep injecting inflation in this way Kuroda would have to keep increasing the rate of balance sheet expansion on an annual basis and the yen would have to keep falling to lower and lower levels.

In a globalized economy currency depreciation is a zero sum game. One man's inflation is another's deflation. The so-called "foolproof path" is only really effective in the case on a single economy (or currency area) but not in the face of a generalised problem. Under current circumstances those whose currencies are forced upwards simply import the deflation/disinflation that is being exported by the the devaluers and on and on we go.

Paul Krugman has been pretty vocal in decrying those who have seen inflation where it wasn't, but what if he himself is falling foul of his own trial-by-fire in seeing inflation where it isn't in Japan inflation expectations? What if the drop in Japanese trend growth is long term and continuing, then why should we really expect the Abenomics experiment to work?

On analyzing their results they found an extremely persistent slowdown in long run growth rates for the G7 as a whole. More surprisingly perhaps, it looks like this slowdown has been ongoing since the 1970s, and is not just a sudden decline after 2008. Averaged across the G7, they traced the slowdown to trend declines in both population growth and labour productivity growth, with the combined impact being a halving in long run GDP growth trends from over 4 per cent in 1970 to just 2 per cent now.

As they also state, the aggregate G7 result is a composite of widely differing trends at the
individual country level. As can be seen from the chart below, the Japanese case is a particularly clear one (the blue lines mark one and two standard error bands).

As it happens, Gavyn Davies' post produced a particularly poignant and cutting response from Paul Krugman - What secular stagnation isn't - in which he argues that secular stagnation "is not the same thing as the argument..... that the growth of economic potential is slowing". He suggests that this "is a really important distinction, because secular stagnation and a supply-side growth slowdown have completely different policy implications."

But this attempt at making a supply-side/demand-side distinction is a strange one, not only because - as Marginal Revolution's Tyler Cowan coherently argues - in the medium to long run supply-side and demand-side are deeply interconnected. It is also confusing because Paul himself has spoken of the Japan problem being one of the country suffering from a "shortage of Japanese", a supply side problem if ever there was one. I would say it should be obvious on simply a common sense level that having a smaller working age population restricts both potential growth AND aggregate demand. Krugman however doesn't see things this way, and argues that:

"If labor force growth and productivity growth are falling, the indicated response is (a) see if there are ways to increase efficiency and (b) if there aren’t, live within your reduced means. A growth slowdown from the supply side is, roughly speaking, a reason to look favorably on structural reform and austerity."

That seems clear enough, doesn't it? If Japan's potential workforce is declining and productivity deteriorating due to an increasingly aged workforce then, roughly speaking, we should favour structural reforms and austerity (Mrs Merkel, are you listening?)

But then comes the catch.

"But if" - on the other hand - "we have a persistent shortfall in demand, what we need is measures to boost spending — higher inflation, maybe sustained spending on public works (and less concern about debt because interest rates will be low for a long time)."

Perhaps the key word here is "shortfall". Shortfall relative to what? To what it was in the past, or to potential demand now. If it is the latter, then there must be something at work now, something beyond simple demographic and productivity dynamics (and the mountain of government debt), that is holding growth back. If that is the case, it would be interesting to know what that "something" was. Since otherwise Japan seems to be heading deeper and deeper into a very risky experiment based on a misunderstanding about what the problem facing the country actually is.

***************************************************************

The above analysis is based on arguments fleshed out in much more detail in my "mini book" the A B E of Economics.

Strangely, while I would suggest the most obviously affected countries are those mentioned above, most of the debate has centered around the US economy. Since it is not at all clear that the US economy is actually suffering from either a liquidity trap or secular stagnation at this point, this has lead many to question whether the idea might not be ill-founded. The Economist, for example, in a revue article (Fad or Fact) of Teulings and Baldwin's Vox e-book on the topic conclude the concept "remains a baggy one", one which is "arguably too capacious for its own good".

Viewed in this light the concept does at times appear vague, and lacking in clear definition. In part this is because Alvin Hansen's original idea was made up of two components, a technological and a demographic one. Naturally if there is a slowdown in the rate of impact of technological innovation then this would be felt equally across those economies which are operating near the technological frontier. But the phenomenon which is being described today as secular stagnation isn't being witnessed equally across all those countries. Economies in both the UK and the US appear to have responded differently to those in Sweden, the Euro Area and Japan, a phenomenon which is obvious to the theory's critics. Thus the Economist author goes on to argue, "it is hard to avoid the conclusion that many of the euro area’s difficulties result from a dysfunctional monetary union rather than a susceptibility to secular stagnation." And it would be hard to disagree with the writer on this count, except... except ....except that there is the awkward little case of what is happening to Japan, a country which as it happens doesn't use the Euro, or in Europe itself to countries like the Czech Republic, Sweden or Hungary that don't use it either.

Which brings us nearer to the demographic part of the argument. Is there any pattern emerging in the way symptoms which look like those which would be presented in cases suffering from secular stagnation are showing up? Well, I would argue there is. I think it is generally accepted that the first affected country was Japan. It was in Japan that a slowdown in GDP growth (not GDP per capita growth) was first noted.

Japan was also the first country were working age population started to turn negative (in 1997) and where the correlation between declining growth momentum in this group and creeping deflation first started to be noticed.

Here's what movements in EU working age population look like.

And here's why I don't think considerations of demography can really justify the secular stagnation thesis in the United States context at the present time.

EU working age populations started to decline in the years between 2009 and 2012. They will now continue to decline for many years to come. In the United States however, while the rate of growth in this population segment has slowed in recent years, it is about to start accelerating again. As Calculated Risk's Bill McBride pointed out, the US Census Bureau now reports that Baby Boomers aren't the largest US cohort anymore, and that the prime working-age force is expected to start growing again in a few years. In other words, in terms of the demographic outlook, the dynamic points to stronger, rather than weaker, economic growth. By 2020, eight of the top ten largest cohorts (five year age groups) will be under 40, and by 2030 the top 11 cohorts will be the youngest 11 cohorts. (see the marvelous animation Bill has at the end of his post).

Not All Europe Is The Same

Naturally, demographic dynamics are not the same in every country across Europe. The two oldest countries on the planet are Japan and Germany with median population ages of around 46. Then comes Italy with with one of 45. I have recently written about the possibility Germany is bogged down in some kind of secular stagnation process. The Economist writer argues that what Europe's economies need are structural reforms, but it isn't clear if he also thinks Germany needs another swathe of these. Long term growth is low in Germany, and inflation pressures are weak. It is not clear, however, that Germany is stuck in any kind of any kind of balance-sheet-recession-type liquidity trap. Loan growth is low, but this may well be a function of the age structure of the population.

It's no big secret really that Italy is suffering long term growth stagnation (which many, like the Economist and Beppe Grillo simply attribute to Euro membership).

And Italy has recently begun to have negative inflation levels.

Next on the list come countries like Austria (median age, 44), Finland (43,2), The Netherlands (42.1), Switzerland (42) and Sweden (41.2). It is striking that both Finland and The Netherlands have recently been suffering from very weak growth and almost constant recessions, while Sweden and Switzerland have an ongoing problem with a deflation threat.

If we fan out a bit, and move over to Eastern Europe, where working age populations are almost universally falling, the sharp fall in growth rates between the years before and the years after the crisis is also pretty noteworthy.

Before the crisis annual growth rates were in the 4% to 6% range, now they are in the 1% to 2% range, and these are all emerging economies with levels of GDP per capital well below the EU average, countries who should in theory be experiencing strong "catch up" growth.

At the same time inflation, which was previously a significant problem, has all but disappeared and in fact deflation risk is pretty general across the region. Normally CEE countries have median ages of around 41, much older than say Ireland with a median age of 35.7, or the United States with one of 37.6.

So we seem to be observing the following pattern: working age population growth approaches zero and starts to turn negative, growth slumps to about 1% a year and falling, and inflation weakens to the point of becoming deflation. If this rough correlation is reasonably valid the next countries where we see secular stagnation setting in are South Korea and China, since working age populations are now in the process of turning there too.

A Simple Mechanism

So how do secular stagnation work? What's the mechanism? Well so far we have been offered two, one from Paul Krugman.

"To have more or less full employment, we need sufficient spending to make use of the economy’s potential. But one important component of spending, investment, is subject to the accelerator effect: the demand for new capital depends on the economy’s rate of growth, rather than the current level of output. So if growth slows due to a falloff in population growth, investment demand falls — potentially pushing the economy into a semi-permanent slump."

A slowdown in the rate of increase in domestic demand leads to a slowdown in investment, and this double slowdown pushes the economy into a dependence on exports and very weak GDP growth. The first place this "underinvestment" phenomenon showed up was in Japan.

Then we have seen it in Germany.

And now the "German" phenomenon has spread to the rest of Europe.

The second pathway through which demographically driven secular stagnation operates was described by a group of IMF economists in a recent research paper: "Is Japan’s Population Aging Deflationary?" Lower demand from older populations (less credit growth) leads to oversupply and deflationary pressure. The first part of the paper abstract runs as follows:

"Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need."

So while there is no definitive answer at this point to the question whether or not what we are seeing is a creeping process of secular stagnation which will gradually spread from one economy to another as the respective working age populations start to contract, there is strong prima facie evidence that there may be, that the theory is worth examining and that the hypothesis should continue to be tested.

Postscript

The above arguments about why the Euro Area countries may have entered some sort of state of secular stagnation are developed in detail and at far greater length in my new book "Is The Euro Crisis Really Over? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Saturday, October 18, 2014

Those who have interest in neither Catalonia nor the issue of journalistic standards will probably find this posting long, tedious, and not especially interesting. Perhaps you might like to stop at this point. Those of you who are interested in one or other of these, well, I invite you to read on.....

To The Editors Of The Economist

I am writing this missive addressed to you as I am outraged, nay scandalized, by the level of your reporting on the Catalan question. The source of my discontent are two recent pieces - both signed by one GT - the first of which appeared on the Charlemagne Blog (Getting to “sí”, 19 September 2014), while the second was published under the rubric The Economist Explains (Catalonia’s independence movement,14 October 2014.)

Of the two, I consider the second much more reproachable since it purports to be an informative document, and not a mere opinion piece. My issue with your journalist is not his opinion - to which any journalist is entitled - but that he attempts to pass off opinion as fact. My view is the that the level of journalism being demonstrated is not what you should be seeking in a publication with your high level of international prestige.

At the end of the day, of course, whether this is the case or not is an editorial decision on your part. I fully understand why the Economist originally took the decision to publish non-editorial unsigned articles, but in the modern age I think this be a double edged sword as it leads to confusion about what is an Op-ed and what isn't. Personally I think the practice is now more trouble than it's worth, but again that's for you to decide.

In order to try and demonstrate my case I have gone to the rather tedious lengths of re-reading the two offending articles and identifying what I consider to be factual inaccuracies (see below).

In a personal mail addressed to me, GT says he admires President Mas, and even describes the new Catalan "consulta" as a brilliant move. It is a pity he couldn't have brought himself to express such opinions in the articles. My reproach is not related to any one phrase or statement, but to a long history of the same over many years.

My feeling is that in the present context, and with so much for the whole of Europe at stake here in Spain both politically and economically in the coming years, what GT does verges on the irresponsible, especially in an article with the header The Economist Explains. Curiously for an article with such ambitions it is striking that the ANC (Assemblea Nacional Catalana) which is the key civil society organisation promoting the independence drive) doesn't get even a mention.

In his mail GT tells me he is critical of Mr Rajoy, but frankly in his last two pieces this criticism is hardly noticeable. My "j'accuse" is based not on this factual inaccuracy (or superficial assessment) or that one, but on the fact that quantity eventually becomes quality. Despite claiming to admire Artur Mas the sum total of GT's "comedy of errors" makes the Catalan President look more like a character from Hotel Faulty, a sort of mediocre, run of the mill politician who was busying himself "ploughing another furrow" when the indy movement snuck up on him and forced him to try to "regain control". He is seen as a politician who is almost permanently under threat from the "Manuel" (or Sancho Panza) type character (Oriol Junqueras, leader of the openly separatist ERC - "my name is Oriol and I come from Barcelona") who is constantly threatening to wreak havoc with his best laid plans. Funnily enough there is a popular weekly satire programme on TV here which does something similar, but that programme, evidently, is just that, satire.

Getting to “sí”

"On Friday Catalonia's parliament passed a so-called “law of consultations”, with a view to allowing Mr Mas to call a referendum on November 9."

This - that what the Catalan Parliament intended to enable under the "law of consultations" was the holding of a referendum - is just plain wrong. The law enables only popular consultations, and this was always its intention. Whether the vote called under the initial decree issued under the law was in fact a referendum is disputed, and vigorously so. The Catalan side argue it was an opinion-sounding vote, with no legal consequences, and have appealed to the Constitutional Court on just these grounds, against the Spanish government submission that it is de facto a referendum. The court has not yet ruled on this issue. When it does it is quite possible that it rule the law as such (possibly with some amendments) falls within the competences assigned to the Catalan Parliament under its charter, but that the question that was to be put is not covered by the law since it may be considered to constitute a referendum. But since the "with a view to" words constitute an opinion about what was in the heads of the members of the Catalan parliament at the time of voting, all I can say is that there is no evidence to support this view.

Now, there is no harm in putting both sides of the argument, but I do think it is incumbent to put BOTH sides of the case. Also, it would be quite legitimate for GT to take the view it was a referendum by another name, but I do think he should make clear that this is his opinion. If you don't mention that the Catalans considered their attempted vote a "consulta" not a referendum - one without any evident legal consequences - then it's hard to make sense of everything that has taken place subsequent to the suspension, and especially it is difficult to explain how the new vote that has been called for the same day with the same questions differs from the suspended one. Apart from the legal framework in which it is to take place, to all appearances it doesn't.

"If Mr Mas obeys and cancels the referendum, his minority nationalist government, propped up by the separatist Catalan Republican Left (ERC), may fall."

Again, GT refers to "referendum" as if it was clear that this is what it would have been. As can be seen, President Mas cancelled the order authorizing the vote but his government didn't fall. It was never going to, and I think only people in Madrid ever believed this to be a possibility. In order to understand why this was always going to be a highly improbable outcome maybe you do need to be familiar with some very simple "game theory".

"In the most extreme one, Mr Mas could stage an illegal referendum, with police moving in to remove urns and Madrid suspending the Catalan regional government's right to rule."

Well let's imagine that President Mas was to call an illegal "referendum" (not totally ruled out, but unlikely since he has continually insisted on his desire to work within the existing legal framework, or at least within his legal advisers' interpretation of it). The scenario GT depicts leaves me with one very basic question: where would these police come from? The number of Guardia Civil and Policia Nacional in Catalonia is very, very small. The vast majority of police in Catalonia are either local (municipal) police or belong to the body known as the Mossos de Esquadra, a Catalan police force under orders to the Generalitat de Catalunya. So this was a silly, unrealistic scenario. If the government in Madrid do move against the Catalan government, in my opinion, it will be through the courts and through cutting-off finances. Maybe even trying to suspend the Statute of Autonomy under which the Catalan Parliament operates.However legal experts here question whether - despite the threats to do so that have on occasion been made - they in fact have the power to do this under the terms of the Spanish constitution. So it is possible that any hypothetical suspension of the "right to rule" may in practical terms need to involve some sort of suspension of the very constitution Mariano Rajoy declares he is determined to defend. That would be ironical, wouldn't it?

"Catalonia cannot negotiate to win more such powers from Madrid, for the simple reason that it already has them."

Well, again this is just an empty silly argument, since it is obvious there will eventually - as in the Scottish case - be third way proposals (maybe even a West Lothian question) as GT admit in his second article. There is no theoretical limit to the amount of devolution that can take place within a federal state. Especially if we start talking here about bi-lateral federalism for Catalonia. Again, he later points out, maybe many Catalans would vote for a new type of arrangement along these lines, and indeed this is why the consultation question is framed in two parts, so people can vote for the option of a (federated) Catalan state within Spain. If GT were to argue that maybe Artur Mas is ambiguous on this point, I would say that view is legitimate. As a democrat I suspect President Mas would go along with what he felt a majority of Catalans wanted. On the other hand I'm not sure I've seen any reference to the fact that there are to be two questions, or any analysis of the significance of this fact in any of his published material.

Catalonia’s independence movement

"The regional government of Catalonia ..... was planning to hold a non-binding referendum on independence on November 9th."

Well again, this is a one side way of putting it (see above) the continual repetition of which brings into question GT's independence on the matter.

"On October 14th the Catalan prime minister, Artur Mas, announced that some form of "consultation", involving "ballots and ballot boxes", would go ahead anyway on November 9th, regardless of the Court's decision."

Well exactly, this is simply the earlier consultation without any decree behind it, since President Mas is gambling that without a decree the Madrid government can't go to the constitutional court to get a decree which doesn't exist suspended. As GT says in his mail to me, it's a brilliant stroke. Since the Catalan Parliament never considered the 9N vote a referendum, neither version could be considered to have legal consequences, the only force they can have is political, in demonstrating people's opinions. At the international level these political effects should not be underestimated, hence, I venture to suggest, Mariano Rajoy's desire that it not take place.

"The two motors of the new wave of separatism are Spain's economic woes and a 2010 Constitutional Court decision to strike out part of a renewed charter of self-government that had been approved at referendum."

This is undoubtedly true, but maybe it would have been helpful to have mentioned WHICH part of the charter was struck down - the declaration that Catalonia is a nation. This is especially relevant since it is at the heart of the current issue, and also in the light of his next comment. The fact that this little word was struck out following an appeal from the Partido Popular to the constitutional court after a "popular participation" protest which involved the collection of a large number of signatures is possibly also relevant. President Mas is simply repeating this performance in reverse.

"Many Catalans, who speak their own language as well as Spanish, believe their taxes pay for poor, lazy southerners to live off government hand-outs."

As well as the fact that they speak that language maybe he could have said a bit more, especially about how the Catalans now feel their language - which was of course banned during the Franco years - is once more under threat. Recent developments in Valencia, the Balearic Islands, Aragon (where there are significant Catalan speaking communities) are seen as a clear sign of an intention to limit use of and familiarity with the language. The most recent Spanish educational reform which attempts to influence the quantity of teaching in Catalan in Catalan schools is also highly contentious and important in understanding the current strength of feeling.

In addition, the second part of his sentence is little better than an Andy Capp type caricature. The quantifier "many" often hides a multitude of sins. Many Germans think something of the kind about Spaniards in general, but I doubt it is a majority. The same is true of Catalans. What Catalans want is to be able to decide what to do with their own resources.

They also want to be recognized as a nation and not continually told there is only one nation - the Spanish one - of which (under the terms of the constitution) they are all compelled to form part (whether they like it or not).

"Mr Mas has been caught unprepared by this wave of separatist enthusiasm. He responded first by demanding new tax-raising powers from Madrid."

Well, this is one of the issues where I feel GT has things totally back to front. Artur Mas, like the ANC - who he somehow manages to avoid mentioning even once in what is supposed to be a background information article - and everyone else, was as he says surprised by the *size* of the 2012 demonstration, and this undoubtedly encouraged him to move forward more quickly with a project he was already working on - the Catalan "national transition" - and recognise the leaders of ANC and Omnium Cultural as legitimate leaders of Catalan civil society.

No man is an island, and President Mas himself had been evolving as part of this growing separatist feeling since 2006. It was around that time he first started talking about moving towards a "national transition". This transition was already conceptualized as creating the institutions necessary to move towards independence. A declaration of some kind of statehood was always going to be the end point. So he was himself fanning the flames. He was not simply a late opportunistic add-on to the developing idea that Catalonia had gone as far as it could within the terms of the 1978 constitution.

On the isssue of the tax proposal GT is just plain wrong: President Mas's tax proposal was not a hasty response to the arrival of a wave of separatism. It was an idea he had been working on all through his years in opposition. Certainly he seems to have been quite happy when Rajoy (perhaps foolishly) greeted this proposal with an outright "no", since this meant he could then move on to the next stage in the project. I think the size of the separatist movement lead him to accelerate his plans, and shorten the time scale of the "national transition".That is all.

"When they [the tax powers] were refused he called a referendum, knowing it was likely to be banned. It has not been enough to convince voters:"

What is the insinuation behind "knowing it was likely to be banned"? That it was all part of a carefully calculated plan - just another step towards the "elections as a referendum move"? Mas as Machiavelli? Or is GT suggesting that he was simply trying to throw sand in the voters eyes, to stall for time. The general gist of his argument leads towards the latter conclusion, so if he wanted to make the former point may I suggest that there are better ways of doing so. Like saying "this was also brilliant".

"Spain's conservative prime minister, Mariano Rajoy of the Popular Party (PP), has refused to call a referendum, which has only stoked support for one"

Mariano Rajoy, to my knowledge, has not been asked to call a referendum at any point, so he has not refused to call one. The Catalan parliament in the spring of this year asked the Madrid one to authorize them to hold one - as had happened with the earlier referendum which was held over the new charter in 2006 - but this time the Madrid parliament refused. Once a referendum became impossible the Catalan parliament decided to go for a "popular consultation" - the legal aspects of the two - as I keep saying - are rather different. I suggest that the fact that GT didn't distinguish between referendum and "consulta" in the first instance leads to this kind of confusion. maybe he himself was confused.

"It [the Spanish government] also refuses to countenance the opposition Socialist Party's “third way” approach, which would involve constitutional reform to give Catalonia still more power and make Spain more federal. Polls show such reforms could bring support for independence below 50%."

See my point above, this is the reason more autonomy could clearly be offered, as happened in the Scottish case. And is indeed one of the few occasions on which GT criticizes Mariano Rajoy.

"Mr Mas's pseudo-referendum is still due to go ahead on November 9th, though it will have no legal consequence."

Well, we're back to the same old issue. What would have been the legal consequence of the suspended vote? None. What will be the legal consequence of the new vote? None. What's the real difference? None.

Essentially the two votes are one and the same - same questions, same date, same ballot papers, same ballot boxes - and serve the same purpose, to find out what those who want to vote think. "No" supporters would not vote in either case, so we are only talking about getting a rough idea of who would vote "yes-yes" in a full referendum.

The use of the expression "pseudo referendum" irks somewhat here, since it sounds remarkably like the Catalan PP leader Alicia Sanchez Camacho's disparaging "refèrendum de costellada" (Sunday afternoon barbeque referendum). Pseudo (unlike say surrogate, or placebo) is normally used very negatively in English.

"The “no” side has either refused to engage or, where it has spoken up, been drowned out."

I dispute this. Both parts. Plenty of people have come to Catalonia from Madrid and other areas of Spain to argue in favour of "no". Both putting the constitutional case for "no" vote (rather than "no" in the vote) and arguing Catalonia is better off inside Spain. What hasn't existed is a "better together" campaign since there has been no third way offer to campaign for, and an assumption that there will be no vote. I also see no evidence of people being "drowned out". Plenty went to the Plaça Catalunya on 12 October (maybe 50,000) to show their support for staying in Spain. If people think that more than a small minority actively oppose independence, then the best way to find out is to have a real referendum and see. Constant insinuation achieves nothing.

GT also misses the key point about the elections as referendum proposal: this - in President Mas's opinion - is the only way to get the "no" side to actually campaign and vote - a key point in his international legitimization strategy."Mr Mas may now be forced to call early elections."

President Mas is not going to be FORCED to call early elections, as GT obviously knew since he explained to me he watched a video of the relevant press conference. The Catalan president is actively promoting them and sees these as the best way forward. In fact he is struggling with the other parties to get them to accept this idea and join a common list.

"The likely winner would be the radical ERC, which would lead a regional government encouraging civil disobedience, if the party sticks to its current position."

So again no, the likely winner wouldn't be ERC but the "yes-yes" vote. Mas has said he won't call early elections unless a common platform is agreed to. His mandate extends to November 2016. He doesn't even need the support of any other party to pass the 2015 budget since he can simply extend the validity of this year's in the same way he did this in 2011 with the 2010 ones he inherited when he came to office.

You could, like Oriol Junqueras suggest he has electoral purposes in taking this stance. That is a matter of opinion. Think again about game theory and the prisoner's dilemma. The outcome of those elections wouldn't, in his opinion, be an immediate UDI, but hey, guess what, Artur Mas's blessed national transition - which it is suggested would last 18 months - during which time an attempt would be made to create the institutional infrastructure necessary for UDI. In fact he has has an advisory body on the national transition at work since the November 2012 elections preparing all the documentation and strategy precisely with this in mind.

Naturally Madrid would probably not stand idly by - see comments above - but that is not what we are talking about here.

Monday, October 13, 2014

“The problem is that Germany has continued to maintain highly competitive labor costs and run huge surpluses since the bubble burst — and that in a depressed world economy, this makes Germany a significant part of the problem.” – Paul Krugman, German Surpluses: This Time Is Different

According to one fairly widespread (and recently much in vogue) theory about the Euro crisis, Germany bears a large part of the responsibility for the current mess. The view is met with a variety of responses inside the country, ranging from horror to amazement. Naturally, if the argument were simply about the way Angela Merkel has handled the crisis – no Eurobonds, no debt forgiveness, systematic fiscal austerity – then possibly some of it could be understood. But no, things go beyond that, Germany has been too successful, too competitive, and this has presented a big problem for its partners who simply haven’t been able to keep up.

This deeper “German bad” argument can take a variety of forms. The country is said to be obsessed with austerity even though all its partners are struggling to find air, it is thought to be guilty of running excessively large current account surpluses, it is accused of not showing sufficient solidarity with its south European partners by being unwilling to run higher inflation: what is more it is said to have benefited from a kind of vendor financing procedure during the good years and then complaining when the customers can’t pay. The list is a long one. The UK economist Simon Wren-Lewis even accuses them of having attained their hegemonic status simply by undercutting everyone else.

“Within the Eurozone, we have a problem created by Germany undercutting pretty well every other economy in the 2000-2007 period. I am not suggesting this was a deliberate policy, but the consequences were not appreciated by any Eurozone government at the time.”

Personally, I think that behind this whole approach there lies a major misunderstanding about just what is going on in Europe (dare I use the word "confusion"). Why is the Germany economy falling back towards a possible recession? Why does a country which recovered so rapidly from the global recession in need itself of stimulus? What we need to look at is why it is that Germany itself has problems. Why it looks so much like Japan, and not the extent which it could be blamed for the obvious economic problems in Italy and France. Instead of crying to the heavens about the country's current account surplus why don't we ask why domestic demand is so weak. Surely not because the country is living through a "balance sheet recession".

What worried me is that people are suggesting remedies - once which they admit might not even work - without getting to the heart of an adequate diagnosis. The nub of the problem is to be found in the following statement in PK's latest post:

"Draghi can try to get traction through quantitative easing, but it’s by no means clear that this could do the trick even under the best of circumstances — and in reality he faces severe political constraints on what he can do."

The argument we are being served up seems at best simplistic: Draghi is good, Schaüble is bad. That may be fine for those of you who like your world polarised in nice Manichean fashion, but would that things were so simple. I just spent a good deal of time writing a blogpost - The Japanisation of Europe - which tried to argue that Mario Draghi is understating the extent of the mess Europe is in, and detailing the shortcomings in his knowledge of what actually happened in Japan. I am no admirer of the intellectual corner Herr Schaüble finds himself in, but I can't help feeling there is a significant element of "good cop" , "bad cop" going on here, with everyone defending the script they've been allotted, still if you like your stories nice and simple.....

What worries me isn't the idealisation of Mario, nor the demonification of Wolfgang, no it isn't that at all, it's those five little words Krugman uses: "it's by no means clear". This vagueness worries me since it rings a bell in my head about a phrase he used on an earlier occassion: Japan's "economy won’t always be in a liquidity trap, or at least it might not always be there." (Monetary Policy In a Liquidity Trap). For someone who wants us to draw the conclusion that it's the other side who are confused this vagueness is a bit rich. Does the policy he is advocating work or doesn't it? I think the guinea pigs have the right to know before giving their permission to the experiment?

You see, it wouldn't be so bad if there were strong grounds for thinking that full blown QE might shock the Euro Area out of its secular stagnation, but as I've been arguing for some time now (see my Paul Krugman's bicycling problem) the logic of Paul's argument (that secular stagnation is ultimately the result of long term fertility trends, and the long term natural interest rate may well be permanently negative) leads to the opposite conclusion: that it probably won't. And growing evidence from the application of Abenomics in Japan seems to confirm that view. To quote Martin Wolf again, "you can't print babies".

There are lots of things wrong with the Euro Area and it's institutions, and much needs to be done, but sending 18 countries on an experiment with consequences that wouldn't be benign and might not work doesn't seem like exactly the best way forward if you're not sure about what you're doing.

Not Simply An Export Model, Germany is the most Japanised of Europe's economies.

This whole “German Bad” approach is fundamentally flawed in my opinion, since while the crisis has revealed many failings in the south European economies – book cooking, corruption and conniving with money hungry developers, the presence of large and systematic extractive networks who were basically living off economic rents – the finger pointing towards their German counterparts smells all too much like saying something like “why did they have to be so good at selling their products.”

Simply cutting wages in the south isn't the answer (although carrying through a more serious internal devaluation involving reducing both prices and wages might be if you want to hold the Euro together). But neither is making Germany less competitive.

Even the idea that Germany has done better than its partners simply by driving down wages doesn’t fit the facts. According to Eurostat, average hourly wages in Germany in 2013 were 31.3 Euros. In Greece they were 13.6 Euros (and 16.7 Euros in 2008), in Spain they were 21.1Euros (and 19.4 Euros in 2008), while in Italy they were 28.1 Euros (and 25.2 Euros in 2008). In fact Germany came 8th in the Euro 18 league as far as hourly salaries goes. The conclusion you should draw from this data is that Germany’s unit labour costs are low not because Germans aren’t paid much, but because they are very productive, and at the end of the day, despite all the bleating about the current account this is the model other members of the Euro Area (including France) not only need to but are compelled to follow: high pay and high productivity. Indeed Paul Krugman more or less admits this reality:

“So while it’s impressive that Germany can run a surplus despite quite high labor costs, and that’s a testimony to the quality of its stuff, ultimately the surplus reflects high savings relative to investment.”

High savings relative to investment is exactly the argument Krugman uses to explain demographically driven secular stagnation: there is insufficient capex as a result of weaker domestic demand. So German savings are a symptom of something, and that something needs adequate diagnosis.

Even a cursory examination of German growth rates – the trend is now down to around 1% - suggests that all is far from well, as do the constant relapses back towards recession. The country simply looks good because all its partners are doing so badly.

What southern Europe needs is a revolution in the mindset and more “better quality” stuff, and no amount of blaming Germany for the situation can get over that. The extractive networks who hold back growth need reforming out of existence.

At the same time the under-investment over-saving phenomenon that characterizes Germany bears a remarkable similarity to what has been happening in Japan, with the strange difference that these days Japan is normally sympathized with and not blamed for all the world’s ills.

The Japanisation of Europe is most evident in the creeping stagnation in the so called core, and above all in Germany. Germany could probably help more with its short term fiscal stance, as Mario Draghi is arguing, if the others had a clearer plan, but at the moment the reform impetus in countries like Spain - unemployment still around 27%, a 3% fiscal deficit in Germany won't shave much off that - is waning severely. Shock measures to address this "unacceptable" unemployment is being neither contemplated or nor even discussed.

But the idea that Germany is stagnating on a temporary basis is absurd. It has been sliding to where it is now for over a decade, and short term stimulus won't be any kind of game changer. Nor are structural reforms likely to make that great a difference, the country has already done a lot of those. They slowed the process down - which is what structural reforms can achieve - but they couldn't halt the inevitable.

You can either argue that Germany goes "full Japanese" and tries live on permanent fiscal injection steroids (which clearly the country never will because that is not what its citizens want) or you can accept that it will just have to try what Keynes recommended, and start learning to manage the consequences of population decline. Obviously there is more, much more, to be done in Southern Europe, but trying to look for the problem where it isn't won't help in that endeavor.

Wednesday, October 8, 2014

“People should seriously consider that Japan’s economy may have fallen into recession despite the weaker yen and a stock rally from the BOJ’s easing and the flexible fiscal policy by Abe’s administration,” said Maiko Noguchi, senior economist at Daiwa Securities. “Initial expectations that the economy could withstand the negative effects of a sales tax hike through a virtuous circle seem to be collapsing.”

"the risks are rising that the economy will later be determined to be in recession,” said Yuji Shimanaka, chief economist at Mitsubishi UFJ Morgan Stanley Securities Co.

Worsening Picture

As noted in my post - Does Abenomics Work? - (published 19 September) the tide of media opinion finally seems to be turning against Shinzo Abe and his economic reform plan for Japan known as "Abenomics". The degree of skepticism being shown only seems to have grown on the back of a slew of recent data confirming the impression that the recovery of economic activity from the post sales-tax slump isn't going to be as easy as either the Japanese government or the Bank of Japan initially thought it would be. As the authors of the Bloomberg report from which the above quotes are taken - Oops Japan Did It Again? Sales-Tax Spurs Recession Debate - put it: "Weak industrial production data from Japan today raises concern that the world’s third-largest economy may be back in recession, challenging Prime Minister Shinzo Abe’s growth strategy." In fact, output which was down 1.5% between July and August (and down 2.9% over August 2013) has fallen in three of the past five months.

Other indicators point in a similar direction. Household spending was down 4.7% year on year in August, and the coincident composite index, which consists of 11 key indicators, including retail sales and industrial production, fell 1.4 points to 108.5, according to the Cabinet Office this week. The August drop was the the first fall since June.

Even corporates are becoming more gloomy. The latest Bank of Japan quarterly Tankan confidence survey fell back three points from June, the second successive fall since it peaked just before the tax hike.

As the FT's Ben McLannahan points out the Tankan numbers also suggested that "the recent drop in the yen – which fell more than 5 per cent against the US dollar in September – remains a double-edged sword for Japan Inc, pushing up profits for big exporters with extensive overseas operations while squeezing the margins of smaller manufacturers, which struggle to pass on the higher cost of imports." Unsurprisingly it is the small manufacturers who are most disgruntled about the impact of Abenomics.

The economy fell between April and June by an annualized 7.1% and even though the rate of decline will have been much slower from July to September all the indications seem to point towards the possibility that growth was negative, which would mean that at least technically Japan is back in recession.

Abe is having more success with inflation, which is running at the highest level in nearly two decades. Yet even the inflation – which is at an annual 1.3% once you strip out the effects of the tax hike – has largely been driven by the rising cost of imports, and there are serious doubts whether even this will be sustained if there are not further yen devaluations. The Tokyo University frequently purchased items index (obtained from supermarket scanner data) shows underlying inflation continuing to ease.

But even the inflation proves to be problematic in a country where wages
constantly fail to rise significantly. The fact that non inflation adjusted
monthly wages rose at the highest rate in I don't know how many years makes a nice
headline, but the fact that real take home pay keeps falling
due to the impact of inflation gives a more realistic description of the difficulties involved in trying to refloat Japanese consumption..

The theory that is being applied assumes that Japan is in some sort of "temporary" liquidity trap due to the presence of a balance sheet recession, but what if the trap is permanent rather than temporary - see my Paul Krugman's bicycling problem - and is the result of the country's demographic evolution. In that case what - apart from all participating in a mass Labour of Sysiphus - do we really hope to achieve?

A policy which is exclusively aimed at attaining a positive natural rate of interest when the natural rate may be permanently negative seems of dubious value at the least, and when this policy in addition proves unable to drag the economy stably out of recession and only benefits the 10% of the Japanese population who have financial assets and senior management in large global companies, then in its application it seems almost to be noxious. A state of affairs which doesn't escape the attention of the average Japanese in the street.

Falling Popularity

The popularity of Prime Minister Shinzo Abe's cabinet was falling sharply going into the summer, forcing him to stage a reshuffle in September. The current approval rating is now back up at 64% but if the country's economic fortunes don't improve it will surely start to head back down again. On the critical question of whether to go ahead with next October's second tax hike, some 68% of those interviewed in the most recent survey say they are opposed while only 28% supported implementation.

Most market participants assume that the Bank of Japan will react to further bad news by increasing the rate of Japan Government Bond purchases, but it is far from clear that this will happen. Indeed only this week Bloomberg reports that members of the governing Liberal Democratic Party's governing council are starting to call for the formulation of an exit strategy from the yen weakening process as the debate over the policy's pros and cons grows steadily more intense.

Meanwhile the Japanese government recently announced that the number of people over 65 reached 25.9% of the population in September – up 1.1 million from a year earlier. Tic-toc, tic-toc.

***************************************************************

The above analysis is based on arguments which are fleshed out in much greater detail in my "mini book" the A B E of Economics.

Saturday, September 20, 2014

By now it should be clear that the monetary experiment currently being carried out in Japan (known as “Abenomics”) is fundamentally different from the kind of quantitative easing which was implemented in the United States and the United Kingdom during the global financial crisis. In the US and the UK QE was implemented in order to stabilize the financial system, while in Japan, and now the Euro Area (EA) the objective is to end deflationary pressures and reflate economies which are arguably caught in some form of liquidity trap.

In particular it is hard not to draw the conclusion that something structural and more long-term is taking place in Japan, and that that something is only tangentially related to the recent global financial crisis. One plausible explanation is that Japan’s long-lasting malaise is not simply a debt deflationary hangover from the bursting of a property bubble in 1992 but rather with the rapid population ageing the country has experienced. If this is the case then the ongoing economic stagnation in Europe may have a lot more to do with the Japan experience than it does with the recent economic dynamics seen in the UK and the US. The reason for this is simple: Europe’s population is the second oldest on the planet after Japan’s. Certainly at first sight the similarity is striking, especially when it comes to working age population dynamics.

So is the Euro Area the New "Japan"?

"Europe is becoming Japanese" is an expression that is being used more and more. People saying this normally point to the fact that German 10 year bund yields recently went under 1% (and hence have started to look like 10 year Japan Government Bonds).

But behind this argument lies some kind of "reverse causality". In Japan JGB yields have been driven to very low levels by central bank intervention, with the BoJ now buying a very large share of all new issue bonds. In Europe, on the other hand, the ECB isn't buying Euro Area sovereigns, the markets are in anticipation of QE. So to talk about the Japanisation of Euro Area yields is a little misleading. Bond purchasers and their models are provoking this downward lurch, not the central bank response to weak growth or creeping deflation. To really push Mario Draghi into Japan-style QE in the short term markets would need to move back into risk-off mode on periphery assets, yet there is little appetite to go for what might potentially become another "widowmaker" trade by taking on a powerful central bank. Yet as long as the bond markets remain relatively well behaved Draghi will try to do as little as possible.

Another argument used to justify the "Japanisation" of the Euro Area idea carries much more clout, and that is the one being used by Paul Krugman based on working age population dynamics. "If you’re worried that secular stagnation might be depressing the natural real rate of interest (the rate consistent with full employment)”, he told blog readers “and you think that demography is a big factor, Europe looks really terrible, indeed full-on Japanese."

Inflation dynamics in Europe also look strikingly similar to those seen in Japan (but with a 20 year lag, see chart below).

The basic idea is that working age population dynamics play a big part in determining movements in aggregate demand and hence inflation. This idea received support from a research paper published at the start of August by a group of IMF economists - "Is Japan’s Population Aging Deflationary?" The first part of the paper abstract runs as follows:

"Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need."

Strikingly Japan entered deflation not in 1992, but in 1997/8 at exactly the point the working age population peaked and in the EA it is happening in 2012/13 - just when EA working age population dynamics turned negative. The correlation may be just an odd coincidence, but it is striking.

Not according to the ECB

Naturally Mario Draghi will have none of this. "I think that the situation in the euro area is quite different from what it was in Japan in the 1990s and early 2000s", he told an ECB press conference in December 2013. He then went on to offer five reasons.

Reason No 1: "we have taken decisive monetary policy measures of great significance at a very early stage, even when, as a matter of fact, inflation was not at the levels at which it is today. It was way higher and way closer to 2% and this did not happen in Japan".

This is the case, but the vast majority of the ECB's non conventional policy measures were intended to avoid financial instability, not to provoke inflation. The measures were largely liquidity oriented not outright "money printing" ones, so they were mainly addressing the monetary policy transmission mechanism - which was broken - not the fact that the refinancing rate was stuck up against the zero bound. There still hasn't been sufficient analysis of why outright deflation didn't hit the Euro Area sooner, but a big part of the story is probably associated with the presence of excessive rigidity in wages and prices and the constant consumption tax and administrative charge increases put in place as part of the deficit containment exercises.

It is noteworthy that in Greece, for example, wage costs came down sharply a long time before the CPI began to fall.

Reason No 2: "We are in the process of doing the asset quality review.......the situation in Japan lasted much longer than it should have because the balance sheets of the banking system and the private sector were burdened, and had to be deleveraged and the action to induce this deleveraging lacked for many years."

Well, maybe, just maybe, the ECB President has his timing a little bit out here. Japan's bubble burst in 1992, and the banks started getting seriously recapitalized in 1998. The global financial crisis hit the Euro Area in 2008, and the AQR - which is supposed to be the prerequisite for realistic recapitalization - is taking place in 2014. The time difference in fact seems to match. So we could also say the necessary action on the part of the ECB also "lacked for many years". Of course, banks in some of the most troubled countries have already been recapitalized once, most notably in Ireland and then in Spain in 2012. But still problems remain, which is why the AQR is taking place. Earlier stress tests have just not been realistic or rigorous enough.

In a process not too dissimilar to the one taking place at the present time in the EA Japanese banks were recapitalized to the tune of 0.4% of GDP in March 2009, and by another 1.5% of GDP in March 1999. The order of magnitude of these recapitalization is not in any meaningful sense larger than that which is taking place in the Euro Area. Following an AQR type process conducted by the recently formed Japanese Financial Reconstruction Commission non performing loans were systematically identified and banks required to recapitalize accordingly. 14.8% of GDP's worth of NPLs were finally identified, a figure not notably different from the current Euro Area one, and well below the levels prevailing in the worst affected countries like Spain and Italy.

Reason No 3: "the situation of the private sector balance sheets is not at all comparable in the euro area. It is not at all comparable with what it was in Japan at that time."

I just think Draghi is wrong about this. The level of credit exposure of Japanese banks to the private sector was not *that* different from the EA one in 2008 (see chart below) and as we have seen the level of distressed lending was pretty comparable.

In effect this whole comparison with Japan in the late 1990s is a
bit flawed, since as will be recalled Abenomics was only introduced in
April 2013. The point being that Japan was still stuck in deflation up to that point (and may still be so when the effects of the devaluation and the tax hike wear off), and so it is a bit hard to pin all this on a couple of bad decisions in 1997 and 1998. Underlying structural factors are at work (liquidity trap, possibly driven by ultra low fertility) and these may be similar in both the European and the Japanese cases.

It is true that the bank of Japan underestimated the scale of the problem between 1992 and 1997, but the same sort of accusation can be brought to the door of the ECB. In both Japan and the EA measures were (and are being) implemented to help banks avoid liquidity crunches in the hope that this will encourage lending, but in neither case has (or is) this had/having any evident success. The poor initial demand for TLTROs being just one example of this problem.

Reason No 4: "countries in the euro area have made significant progress in addressing their structural weaknesses....that’s the fourth difference between Japan in the 1990s and 2000s and us today."

Well, as Draghi himself admitted, the structural reform process in Europe is far from complete (France, Italy) and I think he also underestimates the kinds of reforms which were carried out in Japan at the time. The "lifelong employment" tradition, for example, was ended in the late 1990s.

Reason No 5: "if you look at the inflation expectations in the euro area and the corresponding inflation rates you would see that in Japan the inflation expectations were dis-anchored quite significantly, and for a long period of time, which is not something we are seeing here."

This isn't exactly as straight forward as Draghi makes out either. He himself has accepted in his Jackson Hole speech that EA inflation expectations are not as well anchored as he thought they were, while on the other hand inflation expectations were better anchored in Japan than he seems willing to acknowledge (see chart below showing how 10yr inflation expectations evolved in Japan). That is to say in neither case did the central bank see the problem coming. (Click on image for better viewing)

Bottom line, despite all the denials from Mario Draghi that the Eurozone is not another Japan there are plenty of grounds for thinking that it is steadily becoming one.

Italian Economy Watch

Japan Economy Watch

Hungary Economy Watch

Latvia Economy Watch

Dans Mon Pays

About

Edward 'the bonobo' is a Catalan economist of British extraction based in Barcelona. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".
He is currently working on a book with the provisional working title "Population, the Ultimate Non-renewable Resource".
Apart from his participation in A Fistful of Euros, Edward also writes regularly for the demography blog Demography Matters. He also contributes to the Indian Economy blog . His personal weblog is Bonobo Land . Edward's website can be found at EdwardHugh.net.